2025 is the latest reminder to investors that markets are unpredictable. Investors have endured a roller-coaster ride of euphoric highs and shocking lows, as the new U.S. administration rolled out various tariff policies and made subsequent adjustments to rates and sectors, targeting friends and foes alike. This confusion resulted in volatility which was especially hurtful to stability-seeking fixed income investors hoping to recover from the pain inflicted by rising rates in 2022/2023.

The global trade war will undoubtedly impact interest rates, which further affects fixed income investors. However, the path forward for interest rates remains highly uncertain. If the tariff war causes U.S. GDP to slow, the Federal Reserve (the “Fed”) may be forced to lower interest rates. If it drives inflation higher, the Fed may increase interest rates. If the U.S. realizes stagflation, which features rising inflation with weakening growth, the interest rate path will be very challenging for the Fed. Without having a clear indication of what is to come, collateralized loan obligations (“CLOs”) may help fixed income investors hedge their bets to meet whichever interest rate environment emerges, with stability.

What are CLOs?

CLOs are structured vehicles that issue bonds backed by an actively managed pool of senior secured floating rate corporate loans. The CLOs issued bonds are tranched into different risk categories, each with a different credit rating and yield. The highest-rated tranches (AAA) have priority for payment of interest and principal, before the other, lower rated traches. Mid- and lower-rated CLOs (rated AA, A, BBB, BB) are subordinated to varying degrees, with lower rated CLOs paying higher coupons to compensate investors for higher risk. To understand CLOs in more detail, please see our CLO Primer and CLO Q&A.

CLOs Offer Benefits in All Environments

High Yields: CLOs offer higher yields than those available from other fixed-income investments with similar or even lower credit ratings, such as government or corporate bonds.

Diversification: A key advantage of high-quality CLOs lies in their low correlation with traditional fixed-income assets, including government and investment-grade corporate bonds. Adding CLO bonds to most fixed income portfolios has the potential to reduce overall volatility and, given high CLO yields relative to traditional fixed income, can enhance returns¹.

Strong Credit Fundamentals: CLOs are backed by a diversified pool of senior secured corporate loans, which hold a higher position in the capital structure of borrowing companies. This seniority provides investors a substantial degree of protection. CLOs also offer credit enhancements such as subordination, meaning that lower-rated tranches absorb losses before more senior ones; and overcollateralization, meaning that CLO funds are required to hold corporate loan portfolios with more value than is required to pay back all outstanding CLOs. These features reinforce the credit quality of the senior CLO tranches, which have experienced notably low defaults. This is especially true for AAA-rated traches, which have never experienced a default in their history².

Benefits during Declining Rate Periods

Spread Compression: CLO coupons float, meaning that they are reset periodically at a base rate plus a credit spread. If the base rate declines, the already high spread becomes a higher percentage of the overall yield, making CLO yields even more attractive relative to other types of fixed income. This may drive demand for CLOs, thereby pushing up the price and having the effect of compressing CLO spreads.

The most recent Fed interest rate cutting cycle started on September 18, 2024, with the Fed Funds Rate having been reduced by 100 basis points since that time. Despite these cuts AAA CLOs have outperformed U.S. Treasuries, U.S. corporate bond and the U.S. high yield bond market while exhibiting far lower volatility.

Benefits during Rising Rate Periods

Low Interest-Rate Sensitivity for Stability and Higher Income: As interest rates rise, fixed coupon bonds come under selling pressure as investors demand higher yields. CLOs offer floating-rate coupons, which benefit investors by providing higher income and market price stability in a rising rate environment. This feature was appreciated by investors in 2022; as the Fed increased interest rates, fixed-coupon bonds experienced high volatility, while investors in floating rate CLOs experienced relatively little price volatility and increasingly higher income.

Brompton’s Approach

Faced with volatility and no clear direction for interest rates, high-quality CLOs are a compelling addition to fixed-income portfolios. Higher yields, diversification benefits, strong credit quality, professional management, and supportive attributes in both rising and falling interest rate environments add to CLOs appeal, regardless of the path that interest rates take.

Brompton Wellington Square AAA CLO ETF (TSX: BAAA, BAAA.U) (the “ETF”) is designed to provide high monthly income and capital preservation through investment in an actively managed portfolio of primarily AAA rated CLOs. CLOs are selected by Wellington Square Advisors Inc., the sub-advisor, and will generally range in credit quality from AAA to BBB, with a minimum of 75% of the portfolio invested in AAA rated CLOs.